Working Capital Management

Introduction of study In the present competitive world, every firm, whether big, medium of small, needs working capital to carry on its operations and to achieve its targets. Proper management of working capital is an important role of firm’s life. Working capital is essential to maintain the smooth running of business. No business can run successfully without an adequate amount of working capital.

Inadequacy of working capital may lead the firm to insolvency and excessive working capital implies idle funds, which earns no profits for business.Working capital management policies of a firm have a great effect on its profitability, liquidity and structural health of the firm. A well-designed and implemented working capital management is expected to contribute positively to creation of firm’s value & profitability. A firm is required to maintain a balance between liquidity and profitability while conducting its day-to day operations.

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Liquidity is a pre condition to ensure that firms are able to meets its short-term obligations and its continued flow can be guaranteed from a profitable venture.The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role with in the business. This requires that business must be run profitability.

Profit maximization is generally considered important objective of a business. Profit is also used as a tool for evaluating the performance of management. Profitability directly influences the creation of surpluses. Therefore, Management of working capital is one of the most important aspects of firm’s profitability.

Analyzing the financial statement of the firm helps to make proper decisions about the strengths and weakness of the firm’s operations. These statements are useful in analysis of the profitability of the company by analyzing each individual element to the total figure of the statement. The statements will also assist in analyzing the profitability of the years and with the figures of the competitive firm in the industry for making analysis of relative efficiency. In sri-lanka, selected all listed companies are divided as the sectors by Colombo stock exchange.Here researcher considers Impact of working capital management on profitability of the five firms in trading industry in listed companies and do research based on the five years data between the 2003-2007 1. 2. Research problem Research problem is focused in this research as follows.

1. Does the working capital management impact on profitability of trading firms in sri-lanka? 2 Are the current assets, current liabilities, working capital, current ratio, liquidity ratio, efficieny ratio of selected Trading firms near to the industry average? 1. 3. Objective of the studyThe focus of this study is Impact of working capital management on profitability of the trading industry in listed companies in srilanka . The basic objective of the study is. • Assess the relationship between working capital and financial performance. Sub objectives are • Identify the need and importance of working capital • To analyze the financial position of trading firms 1.

4. Significance of the study This study will help to know how to impact on working capital on profitability of selected Trading firms. This study also helps to estimate the working capital decisions on the companies’ profitability.Therefore, to estimate profitability, financial, and effectiveness of firm and find out the weakness of the firm. This research will help to know profitability and compare with competitive firms. It is important to improve the competitiveness and liquidity of the trading sector in order to enhance its efficiency.

As well as, this study will create the further research question for further investigation in future. The fast growing but large company also makes use of current liability financing. For these reasons, the financial manger and staff devote a considerable portion of their time to working capital matters.Thus, working capital management of selected trading firms is most important. 1.

5. Chapter outline Chapter one includes background of the study, research problem, objective, significance, chapter outline of the study The second chapter consists of the detailed literature survey of the study. Literature survey of the study describes concepts of working capital, need for working capital, operating cycle concept, permanent and variable working capital, factors determining working capital, excess and inadequate working capital, ratio analysis, overtradingThe third chapter is allocated to discuss the methodology and conceptualization of the study in detail. That is research problem will be conceptualized based on the literature review.

Hypotheses are formulated according to the conceptual model and literature review. Next operationlalization, data collection techniques and method of analyzing impact of working capital management on the profitability of trading firms. The fourth chapter presents survey data presentation, which gathered through secondary data from annual report published by trading firms.

Then data analyses are made by correlation analysis, regression analysis.These data are presented by using tables. The fifth chapter will discuss the findings of the research based on the presented and analyzed data. The, hypothesis will be tested. Finally, it indicates conclusion and suggestion for further research.

CHAPTER-02 LITERATURE REVIEW 2. 0 Introduction In this chapter, the discussion is focused up on the existing literature that describes what is already identified the concepts and theories about the research problem and already carried out the research findings about working capital management and financial performance. 2. 1 Review of theoretical concept 2. 1. 1 Meaning of working capitalEvery Business needs funds for two purposes- for its establishment and to carry out its day – to- day operations. Long – term funds are required to create production facilities through purchase of fixed assets such as plant and machinery etc. Funds are also needed for short – term purpose for the purchase of raw materials, payment of wages and other day – today expenses etc.

These funds are known as working capital. In simple words, working capital refers to the part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories.In the words of shubin, “working capital is the amount of funds necessary to cover the cost of operating enterprise” According to Genestenberg, “circulating capital means current assets of a company that are changed in the ordinary course of business from one from to another, as for example, from cash to inventories, inventories to receivables, receivables into cash.

” (Shashi K. Gupta, Neeti Gupta 2005P. 6.

1) 2. 1. 2 Concepts of Working capital Management The concept of working capital has been a matter of great controversy among the financial wizards.Different views on working capital can be classified into two groups, 1. Gross working capital According to this concept, working capital refers to the sum of all currents assets of the enterprise employed in business process. This is a going concern concept, since the financial manager is highly concerned with the management of assets with a 2. Net working capital This concept represents excess of current assets over current liabilities.

It is also that portion of a firm’s current assets which is financed by long-term funds.Net working capital = current assets- current liabilities (I. M PANDY 1999 p807-808) 2. 1. 3 Kinds of working capital Working capital can be classified into two categories on the basis of time, 1. Permanent or Fixed working capital Permanent working capital represents current assets required on a continuous basis over the entire year. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensure uninterrupted production and sales.

Likewise, some amount of funds remain tied in receivable when the firm sells goods on credit items.Some amount of cash has also to be held by the firm so as to exploit business opportunities, meet operational requirements and to provide insurance against business fluctuations. Thus minimum amount of current assets which the firm has to hold for all time to come to carry an operation at any time is termed as permanent or regular working capital. Permanent working capital has the following characteristics. 2. Temporary or Variable working capital It represents the additional assets, which are required at different times during the operating year additional inventory, extra cash.

It is temporarily invested in current assets and possesses the following characteristics. Y Temporary working capital Permanent working capital X Time Fig-1:-permanent and temporary working capital From fig-1, it is clear that the need for regular working capital remains the same for whole the year, where as variable working capital needs are some times high and some times low. In a going concern, the need for working capital goes on rising because of increase in the level of business activities. It is presented in figure-2 Y [pic]X TimeFig-2:-permanent and temporary working capital 2.

1. 4 Operating Cycle Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and this cash flows out again in exchange for other current assets. Hence it is also known as revolving capital.

The circular flow concept of working capital is based upon this operating or working capital cycle of a firm. The cycle starts with the purchase of raw material and other resources and ends with the realisation of cash from the sale of finished goods.It involves purchase of raw material , its conversion into stock of finished good through work-in-progress with progressive increasement of labour and service costs, conversion of finished stock into, debtors and receivables and ultimately realitisation of cash and this cycle continues again form cash to purchase of raw material and soon. The speed / time duration required to complete one cycle determines the requirements of working capital- longer the period of cycle, larger is the requirement of working capital. Operating cycle of manufacturing firm Source: I. M. PANDEY, 1999, P 810 2. .

5 Importance of operating cycle The application of operating cycle concept is mainly useful to ascertain the requirement of cash working capital to meet the operating expenses of a going concern. This concept is based on the continuity of the follow of values in a business operation.This value usually in a going concern.

Centre, mainly around the operational activities of a business in any period. This is an importance concept because the longer the operating cycle, there more working capital funds the firms needs. The management must ensure that this cycle does not become too long. Thus oncept more precisely measures the working capital fund requirements, traces its changes and determinants the optimum level of working capital requirements. [TAXMANN 2003, P 654] 2. 1. 6 Factors determining the working capital requirements. The working capital requirements of a concern depend upon a large number of factors such as nature and size of business, the character of their operations, the length of production cycles, the rate of stock turnover and state of economic situation,.

It is not possible to rank them because all such factors are of different importance and the influence of individual factors changes for a firm over time.However, the following are important factors generally influencing the working capital requirements. 1. Nature or Character of business. The working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like electricity, water supply and railways need very limited working capital because the offer cash sales only and supply services, not products as such no funds are tied up in inventories and receivables. On the other hand, trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets like inventories, receivables and cash.

The manufacturing undertaking also requires sizable working capital along with fixed investments. 2. Size of business or Scale of operations The working capital requirements of a concern are directly influenced by the size of its business, which may be measured in terms of scale of operations. Greater the size of a business unit, generally larger will be the requirements of working capital. However, in some cases even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantage of mall size. 3.

Production policy In certain industries, the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy. The production could be kept either steady by accumulating inventories during slack periods with a view to meet high demand during the peak season. If the policy is to keep production steady by accumulating inventories it will require higher working capital. 4. Manufacturing Process or Length of production Cycle.

In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required. The longer the manufacturing time, the raw materials and other supplies have to be carried for a longer period in the process with progressive increment of labour and services cots before the finished product is finally obtained. Therefore, if there are alternative processes of production, the process with the shortest production period should be chosen. . Working capital Cycle.

In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw material and stores, its conversion into stocks of finished goods through work-in-progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realization of cash and this cycle continues again from cash to purchase of raw material and so on. 6. Credit policyThe credit policy of a concern in its dealings with debtors and creditors influence considerably the requirements of working capital. A concern that purchases its requirements on credit and sells its products or services on cash requires lesser amount of working capital. On the other hand a concern buying its requirements for cash and allowing credit to its customers, shall need larger amount of working capital as very huge amount of funds are bound to be tied up in debtors.

7. Rate of growth of business. The working capital requirements of a concern increase with the growth and expansion of its business activities.Although, it is difficult to determine the relationship between the growth in the volume business and the growth in the working capital of a business, yet it may be concluded that for normal rate of expansion in the volume of business, We may have retained profits to provide for more working capital but in fast growing concerns, We shall require larger amount of working capital.

8. Earning capacity and Dividend policy. Some firms have more earning capacity than others due to quality of their products, Monopoly conditions etc.Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital. The dividend policy of a concern also influences the requirements of its working capital. A firm that maintains a steady high rate of cash dividend irrespective of its generation of profits needs more working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend.

9. Price Level Changes. Changes in the price level also affect the working capital requirements.Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets. The effect of rising prices may be different for different firms.

Some firms may be affected much while some others may not be affected at all by the rise in prices. 10. Other factor.

Certain other factors such as operating efficiency management ability, irregularities of supply, import policy, asset structure, importance of labour, banking facilities, etc also influence the requirements of working capital. . 1. 7 Excess and inadequate working capital Business should maintain sound position of working capital.

The amount of working capital should neither be too excessive, nor too much inadequate. The working capital in excess of the requirement will reduce profitability as the funds will remain unutilized. Controrily, if the amount of working capital is less that what it is required, the production process may be hampered. It will reduce the sales and consequently the profitability of the business will be adversely affected. 2. 1.

8 Management of working capitalManagement of working capital therefore, is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter- relationship that exists between them. In other words it refers to all aspects of administration of both current assets and current liabilities . Working capital management (WCM) is the management of short-term financing requirements of a firm. This includes maintaining optimum balance of working capital components – receivables, inventory and payables – and using the cash efficiently for day-to-day operations.Optimization of working capital balance means minimizing the working capital requirements and realizing maximum possible revenues. Efficient WCM increases firms’ free cash flow, which in turn increases the firms’ growth opportunities and return to shareholders.

Even though firms traditionally are focused on long term capital budgeting and capital structure, the recent trend is that many companies across different industries focus on WCM efficiency. The basic goal of working capital management is to manage the current assets and current liabilities of a firm in such a way that a satisfactory level of working capital is maintained.Working capital management policies of a firm have a great effect on its profitability, liquidity and structural health of the organization. In this context, working capital management is three dimensional in nature: (1) Dimension I is concerned with the formulation of policies with regard to profitability, risk and liquidity. (2) Dimension II is concerned with the decisions about the composition and level of current assets. (3) Dimension III is concerned with the decision about the composition and level of current liabilities. (Shashi K.

Gupta, Neeti Gupta 2005 P. 6. 12) 2. 1.

9 Previous research findings on working capital Management. The study of Grablowsky [1976] and others showed a significant relationship between various success measures and the employment of formal working capital policies and procedures. Walker and Petty [1978], Deakins et al [2001] said that managing cash flow and conversion cycle is a critical component of overall financial management for all firms, especially those who are capital contrained and more reliant on short term sources of finance.

Carpenter and Johnson [1983] provided that there is no linear relationship between the level of current assets and revenue systematic risk of US firms. Pinches 1991, Brigham and Ehrhardt 2004, Moyer et. al.

2005, Gitman2005). Said that , there is a long debate on the risk/return tradeoff between different working capital policies. For the first time, Soenen [1993] indicated that a negative correlation between the length of net trade cycle and return on assets.Lamberson [1995] said that the most of the financial managers’ time and efforts are allocated in optimizing the level of current assets and current liabilities back towards optimal levels. Jarvis et al [1996] concluded that the success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements. Pandy I M & Perera K L W [1997] suggested that The managing director plays a major role in formulating formal or informal policy.

Company size has an influence on the overall working capital policy (formal or informal) and approach (conservative, moderate or aggressive) Finance manager is the responsible for managing working and review period. capital components. Stretching of credit payment and ageing schedule are the primary tools of managing disbursement float and controlling debtors respectively. Material requirement planning (MRP) and perpetual inventory control (PIC) system are key techniques of inventory management. Company profitability and working capital policy influence the payable management and working capital finance respectively.

Most of the companies take cash discounts, but their annual cost of working capital funds is high that ranges between Current and cash budget are major techniques of working capital, 15-20%. planning and control. Company profitability has an influence on the methods of working capital planning and control. Companies sometimes consider working capital changes when they evaluate capital budgeting.

Most of the companies in this study use bank interest rate as a hurdle rate for evaluating the working a comparison of the working capital practices of the Sri Capital changes.Lankan companies with the USA companies reveals a lot for similarities. The basic difference is in terms of the use of computerized system and the opportunity to invest surplus cash in the money market instruments. Herbert J. Weinraub and Sue Visscher [1998] found that there is a high and significant negative correlation between industry asset and liability policies. Relatively aggressive working capital asset management seems balanced by relatively conservative working capital financial management.The study undertaken by Peel et al [2000] revealed that small firms tend to have a relatively high proportion of current assets, less liquidity, exhibit volatite cash flows, and a high reliance on short-term debt. Jain and Kumar (1999) examined and compared that current liability management practices of select companies in India and South-East Asia.

Accounts payable, and short-term loans and advances, were found to be the two major ingredients of total current liabilities. Further, the majority of the sample companies in India and SEA indicated that suppliers offered cash discount facility for prompt payment.Most of the sample companies from India, Singapore and Malaysia did not seem to use any ‘manual’ for working capital management The length of operating cycle had been stated as the basis of working capital determination in India, while, percentage of budgeted production/sales had been ranked as the primary basis in Singapore and Malaysia for that purpose. They also revealed that the majority of the sample companies in India, Singapore and Malaysia had experienced occasional shortage as well as surplus of working capital.Jain and Yadav (2000) conducted an empirical study on the comparative current assets management practices of corporate enterprises in India, Singapore and Thailand.

It was found that the vast majority of the sample companies in India as well as Singapore and Thailand had singled out bank overdraft/cash credit as the major source of dealing with cash deficit situations. The survey also found the multiple ways in which surplus cash was used by the corporate firms from the sample countries.Indian corporate firms followed the practice of deploying excess cash primarily by investing in short-term marketable securities, retiring short-term debt and making deposits with bank for short period. Whereas, deposit with bank and retiring short-term debts were the preferred outlets for Singapore corporate enterprises and Thai firms. Most of the corporate firms in India generally offered cash discount facility to debtors, while their counterparts from Singapore and Thailand (all) did not follow the policy of offering discount to their debtors.Two-thirds of corporate firms in India charged penal interest on overdues, whereas majority of the firms both in Singapore and Thailand did not charge any penal interest on overdue accounts.

William Muffee Visemith [2001] said that Cameroon Development Corporation (CDC) is a very large corporation and working capital problems are very likely The study found that CDC has acute working capital problems resulting in losses These problems stem from poor working capital management approaches employed over the years.Every organization must seek a point of balance in its working capital in order to avoid a loss-making situation. Dr. Santanu Kr. Ghosh, Santi Gopal Maji [2002] indicated that the Indian Cement Industry as a whole did not perform remarkably well during this period Filbeck and Krueger [2005] highlighted that the importance of efficient working capital management by analyzing the working capital policies of financial industries in USA. According to their findings, working capital practices were significantly different overtime within the industries.Similar studies are conducted by Gombola and Ketz [1983] Soenen [1993] Max well et al [1998] and Long et al[1993].

Filbeck and Krueger [2005] said that business success heavily depends on the ability of financial executives to effectively manage receivables, inventory and payables. Md. Sayaduzzaman [2006] found that The efficiency of working capital management of British American Tobacco Bangladesh CompanyLtd. is highly satisfactory due to the positive cash in flows, planned approach in managing the major elements of working capital.Applications of multi-dimensional models of current assets mix may have positive impact on the continuous growth & development of this multinational enterprise. This depends on co-operation of the stakeholders and business environment in the context of globalization.

Appuhami, B A Ranjith [2008] found that firms’ capital expenditure has a significant impact on working capital management. The study also found that the firms’ operating cash flow, which was recognized as a control variable, has a significant relationship with working capital management.CFO Research Services (a unit of CFO Publishing Corp. ) launched a research program to explore working capital management among midsize and large U. S. companies. [2008] Through a survey and interview program, They sought to understand the relative importance of working capital management, the barriers companies face when they try to improve working capital management, and the steps they take to do so. Pradeep Singh [2008] found that the size of inventory directly affects working capital and it’s management.

Size of the inventory and working capital of Indian Farmers Fertilizer Cooperative Limited (IFFCO) is properly managed and controlled compared to National Fertilizer Ltd. (NFL). Anita Agrawal, S. C.

Bansal,[ ] showed that for some of the policy issues of WC, IC and their JV/WOS follow the same practices, while for some of the aspects they have different experiences. Indian firms and their overseas units have same opinion regarding objectives, concepts, frequency of revision of WC policy, determination, experience of shortage of WC and its consequences, reasons of excess WC and impact of environmental factors on WCM.It has been observed that on the whole the basic concepts of WCM remain same irrespective of the location of the firm, however, some differences appear due to distinct size, environment and goodwill of overseas ventures in their respective markets that makes the WCM of these units more complex. Michael J. Peel ; Nicholas Wilson [ ] indicated that a relatively high proportion of small firms in the sample claimed to use quantitative capital budgeting and working capital techniques and to review various aspects of their companies’ working capital.In addition, the firms which claimed to use the more sophisticated discounted cash flow capital budgeting techniques, or which had been active in terms of reducing stock levels or the debtors’ credit period, on average tended to be more active in respect of working capital management practices. 2. 2 financial performances The financial condition of a business organization of a business organization would depend on the resources it owns and the obligations it has to meets.

Companies carry out various activities to make profits, and to generate wealth for further growth.Finance is considered as the most important for these activities. The actions of managers have financial consequences for the business firm.

Therefore it is imperative that they know the importance of finance functions and their linkage with their own activities. (I. M. pandey, 1997) Hence financial position or condition of the firm should be assessed and future position of the companies should predict. To make the business activities in order to make profit, it would be necessary to keep the financial position favorably.

Hence the present study is initiated to predict the financial position of the firms and to find out the linkage between financial position and profitability. Financial statements provide information about the financial positions of an enterprise that is useful to a wide range of users in making economic decisions. (chartered institution,1997) Evaluating the financial performance of the firm, in particular is profitability is required in order to potential changes in the economic resources that it is likely to control in the future.

In formation contained in financial statements is organized to enable users of the financial statements to draw conclusions concerning the financial well-being and performance of the reporting entity. In about performance is useful in predicting the capacity of the enterprise to generate cash flows its existing resource base. Information contained in the statement is used by management, creditors, investors and others to form judgment about the operating financial performance and financial position of the firm.Management should be particularly interested in knowing the financial strengths of the firm to make their best performance and to be able to spot out the financial weakness. Each organization should therefore be in position of to repay the debts.

In this way financial ratios are useful for assessing the financial health of a business firm. Financial analysis is the process of identifying financial strengths and weakness of the firm by properly establishing relation between the items of the balance sheet and the profit and loss account.They are also interested in the firm’s financial structure to the extent it influences the firm’s earnings ability and risk. The management of the firm would be interested in every aspect of financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently, and that the firm’s financial condition is sound. 2. 2. 1 Ration Analysis Ration analysis involves comparing one figure against another to produce a ration and assessing whether the ration indicates a weakness or strength in the companies, affairs.

Several ratios can be calculated from accounting data contained in financial statement. These rations can be grouped in to following categories. 1. Liquidity ratios 2. Leverage ratios 3. Activity ratios 4.

Profitability ratios 2. 2. 2 Usage of accounting ratios Ratios can be profitability used for judging the performance and financial positions of a business undertaking company. The various ratios can be used for the following purposes. * To compare the performance of a firm over a period of time. * To make inter firm comparisons. To compare the performance of firm against the whole industry or against per determined standards. (1) Liquidity ratios “Liquidity” means a company’s ability to meet its current liabilities.

Liquidity ratios measure the ability of a firm to meet its current obligations. In fact, analysis of liquidity needs the preparation of the cash budget and the cash flows statement but liquidity ratios provide a quick measure of liquidity. A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. A very high degree of liquidity is bad since idle assets earn nothing.Therefore, it is necessary to strike a proper balance between liquidity and lack liquidity. The most general and frequently used liquidity ratios are current and quick ratio. (a) Current ratio The current ratio compares a company’s total current assets with its total current liabilities. (b) Quick ratio This ratio is more sever test of short term solvency of company.

This ratio is obtained by dividing quick assets. (2) Leverage ratios To judge the long –term financial position of the firm, financial leverage or capital structure ratios are calculated.These ratios indicate mix of debt and owner’s equity in financing the firm’s assets. (a) Debt ratio Several debt ratios may be used to analyze the long-term solvency of a firm. This ratio is calculated by dividing total debt (TD) by capital employed. (b) Debt -equity ratio Is relationship describing the lenders contribution for each rupee of the owners’ contribution is called debt-equity ratio. It is calculated by dividing total debt by net worth. (c)Interest coverage ratio Interest coverage ratio shows the number of times the interest charges are covered by funds that are ordinarily available for their payment.

It is calculated as earning before dereciation, interest and taxes (EBDIT) divided by interest. (3) Activity ratios Activity ratios, also known as efficiency or turnover ratios, measure how effectively the firm is using its assets. Activity ratios indicate how much a firm has invested in a particular type of asset relative to the revenue the asset is producing. These ratios are usually calculated on the basis of sales or cost of sales. Some of the activity ratios are as follows. (a) Inventory turn-over ratio It indicates the efficiency of the firm in producing and selling its product. t is calculated by dividing the cost of good sold by the average inventory. its assets.

These ratios are also called turn-over ratios, because they indicate the speed with which assets are being converted in to sales. (b) Debtor turn-over ratio It indicates the number of times debtors turnover each year. Debtor turnover is calculated by dividing total sales by the year end balance of debtors (c) Debt collection period Debt collection tells us how many days it takes to collect average accounts receivable. (4) Profitability ratios A company should earn profits to survive and grow over a long period of time.Some firms always want to maximize profits at the cost of employees, customers and society. The profitability ratios are calculated to measure the operating efficiency of the company.

Generally; two major types of profitability ratios are calculated. * Profitability in relation to sales * Profitability in relation to investment (a) Gross profit ratio This ratio is known as the gross profit to sales ratio or the gross profit percentage. (b) Net profit ratio This ratio is also known as net margin or net income percentage. It measures the rate of net profit earned on sales.

c) Return on investment (ROI) It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making profits. ROCE is one of the most important profitability ratios which assess how much the capital invested has earned during the period. ROCE is an opportunity cost to the potential investor and when making decisions investor will always compare the return which the entity will generate as opposed with the return they can earn on other investments. ie Bank’s investment rates. (d)Return on Equity (ROE)Measures again return on investment but targeting on ordinary shareholders. This ratio is specifically for shareholders and is aimed at measuring the return they should expect from their shares in the business 2. 2. 3 Previous research finding on financial performance.

Johnson (1970) found that, cross sectional stability of ratio groups for retailers and primary manufacturing sectors. Kerry Cooper [1984] said that the selected aspects of how foreign exchange risk—the potential impact on a MNC’s profitability, net cash flows, and market value of a change in exchange rates—may affect working capital managementChu et al (1991), concluded that financial ratios groups were significantly different from those of industrials firms’ ratios as well as these ratios were relatively stable over five years period. The study conducted by De Chazal Du Mee (1998) revealed that 60% enterprises suffer from cash flow problems. Gardner et al (1986), Weinraub and Visscher (1998) suggested that more aggressive working capital policies are associated with higher return and higher risk while conservative working capital policies are concerned with the lower risk and return.Berry et al (2002) found that small manufacturing enterprises have not developed their financial management practices to any great extent and they conclude that owner- managers should be made aware of the importance and benefits that can accrue from improved financial management practices.

Marie- Joe Bou-Said and Philippe Saucier (2003) said that major problem of failed banks was not inefficiency of management, but below standard capital adequacy and considerable problems in their assets quality. Significantly above average efficiency of ailing banks could be explained by a survival strategy that pushed them to drastically improve management.Jed DeVaro, October 22,[ 2004] suggested that team production does in fact improve Financial performance for the typical establishment but that self-managed or autonomous teams do no better than closely supervised or non-autonomous teams. It also finds that the magnitude of benefits to establishments that are helped by teams far exceeds the magnitude of costs to establishments that are hurt by teams. Finally, this study finds two interesting patterns of correlations among the unobserved determinants of teams, autonomy, and financial performance.First, unobserved factors that increase the propensity to engage in teams are positively correlated with unobserved determinants of financial performance. Second, unobserved factors that increase the propensity to grant teams autonomy are negatively correlated with unobserved determinants of financial performance when teams are used.

2. 3 Working capital management and financial performance. A well designed and implemented working capital management is expected to contribute positively to the creation of a firm’s value.The importance of cash as an indicator or of continuing financial health should not be surprising in view of its crucial role with in the business. In the process, an- asset- liability mismatch may occur which may increase firm’s profitability in the short run but at a risk of its insolvency. On the other hand, too much focus on liquidity will be at the expense of profitability. A large number of business failures have been attributed to inability of financial managers to plan and control properly the current assets and current liabilities of their firms.Working capital management is of particular importance to the firms.

With limited access to the long- term capital markets, firms tend to rely more heavily on owner financing, trade credit and short- term bank loans to finance their needed investment in cash, accounts receivable and inventory. Therefore there is significant relationship between working capital and financial performance of the firms. Studies in the UK and the US have shown that weak financial management particularly poor working capital management and inadequate long- term financial- is a primary cause of failure of business. . 3. 1 Previous research findings on working capital management and financial performance. Some initial work by Gupta [1969] and Gupta Huefner [1972], the findings of both researchers were that differences exist in mean profitability, activity, leverage and liquidity ratios amongst industry groups.

Smith [1980] said that management of short-term assets and liabilities warrants a careful investigation since the working capital management plays an important role for the firm’s profitability and risk as well as value.Gardner et al [1986], and Weinraub and Visscher [1998] as well as in accordance with Afza and Nazir [2007] produced that the negative relationship between the aggressiveness of working capital policies and accounting measures of profitability. Peel and Wilson [1996] have stressed the efficient management of working capital, and more recently good credit management practice as being pivotal to the health and performance of the small firm sector.The pioneer work of Shin and Soenen [1998] and the more recent study of Deloof [2003] have found that a strong significant relationship between the measures of working capital management and corporate profitability. Their findings suggest that managers can increase profitability by reducing the number of day’s accounts receivable and inventories. This is particularly important for small growing firms who need to finance increasing amounts of debtors.Narasimhan and Murty [2001] stressed on the need for many industries to improve their return on capital employed [ROCE] by focusing on some critical areas such as cost containment, reducing investment in working capital and improving working capital efficiency.

The recent work of Howorth and Westhead [2003] suggested that small companies tend to focus on some areas of working capital management where they can expect to improve marginal returns for small and growing businesses, an efficient working capital management is a vital component of success and survival. i. both profitability and liquidity [Pell and Wilson 1996]. They further said that smaller firms should adopt formal working capital management routines in order to reduce the profitability of business closure, as well as to enhance business performance.

Later on, Deloof [2003] analyzed that large Belgian firms and the results confirmed that by reducing the inventories and average collection period the Belgian firms could improve profitability. Deloof M. [2003] suggested that managers can increase corporate profitablity by reducing the number of days accounts receivable and inventories.Less profitable firms wait longer to pay their bills. Harris &Andrew [2005] suggested that working capital management has become the Achilles’ heel of scores of finance organizations, with many CFOs struggling to identify core working capital drivers and the appropriate level of working capital. Pedro Juan Garcia-Teruel, Pedro Martinez-Solano conducted a survey in 2006. The results, which are robust to the presence of endogeneity, demonstrate that managers can create value by reducing their inventories and the number of days for which their accounts are outstanding.Moreover, shortening the cash conversion cycle also improves the firm’s profitability.

Teruel and Solano [2005] suggested that managers could create value by reducing their firm’s number of day’s accounts receivables and inventories. Similarly, reducing the cash conversion cycle also enhance the firm’s profitability. In the Pakistani context, Rehman [2006] concluded that there is a significant negative relationship among working capital ratios and returns of firms. Further more, managers can create a positive value for the shareholders by reducing the cash conversion cycle up to an optimal level.Similar studies on working capital and profitability includes Smith and Begemann [1977], Ghosh and Maji [2004] and Lazaridis and Tryfonidis [2006]. Kesseven padachi [2006] has concluded that increasing trend in the short-term component of working capital financing.

T. Afza and M. S. Nazir [2007] found that negative relationship between working capital policies and profitability validating the findings of Carpenter and Johnson [1983] and found no significant relationship between the level of current assets, current liabilities and risk of the firms.Anup Chowdhury and Md Muntasir Amia [2007] said that a positive correlation has been found in the mathematical model, between current asset management and financial performance of pharmaceutical firms. Thus, it is evident that for the overall performance of this industry, working capital plays a vital role.

Robert Kieschnick, Mark Laplante, and Rabih Moussawi [2007] suggested that 1. Firms are more valuable if they manage their working capital more efficiently. 2. On average, firms do appear to over invest in operating working capital, but 3.This relationship is primarily driven by firms where managers are protected from either internal or external discipline or where managers have little equity in their firms. Vedavinayagam Ganesan [2007] found evidence that even though “days working capital” is negatively related to the profitability, it is not significantly impacting the profitability of firms in telecommunication equipment industry. T.

C. Narware [ ] said that working capital management and profitability of the company disclosed both negative and positive association.In addition, working capital leverage of the company concluded, the increase in the profitability of the company was less than the proportion to decrease in working capital. A. D. LIYANADE. ;A.

R. AJWARD [ ] revealed that there is an intense negative relationship between working capital and profitability of commercial banks. That means, higher the investment in working capital lower the profitability’s whole all most all commercial banks had been able to maintain adequate working capital during the period concerned. CHAPTER-03 METHODOLOGY 3. Introduction The purpose of this research is to contribute towards a very important aspect of Financial management known as working capital management with reference to Sri Lanka Here the relationship between working capital management and its impact of profitability of Trading firms listed on Colombo stock Exchange for a period of five years from 2003-2007. This chapter describes the methodology that has been followed through out the research. In this chapter, research problem will be conceptualized based on the discussion in the literature review.

Further, the way of research sample were selected and data collection techniques, methodology and limitations are explained. 3. 1 Conceptualization Based on the research question, the following conceptual model may be constructed. Figure 3. 1 conceptual model [Source developed by researcher] The primary aim of this paper is to investigate the impact of working capital management on profitability of trading firms in srilanka. This is achieved by developing this conceptual model. In this model profitability is dependent variable.

Return on capital employed and net profit ratio are used as measures of profitability.Efficiency ratios (Inventory conversion period, Debtors conversion period, Creditors conversion period and cash conversion period) have been computed measure of working capital management as independent variable and relation between working capital management and profitability is investigated. 3. 2 Definition of key concepts and variables 1. Working capital management Working capital management (WCM) is the management of short-term financing requirements of a firm.

This includes maintaining optimum balance of working capital components – receivables, inventory and payables – and using the cash efficiently for day-to-day operations.Optimization of working capital balance means minimizing the working capital requirements and realizing maximum possible revenues. Efficient WCM increases firms’ free cash flow, which in turn increases the firms’ growth opportunities and return to shareholders. 2. Efficiency ratio Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its assets. These ratios are also called turn-over ratios, because they indicate the speed with which assets are being converted in to sales. 3. Profitability ratio The profitability of a company can be reliably analyzed with the help of profitability ratios.

These ratios are of particular interest to the owners and the management. 3. 4 Research Sample According to this research, All trading firms are selected from the hand book of listed companies of sir lanka from 2003 – 2007.

3. 5 Data collection Data collection is important for any research. There are two types of data, namely primary data and secondary data. This study is carried out based on secondary data. This secondary data was collected from hand book of Listed companies published by the Colombo stock exchange. 3.

6 Methodology Data analysis will be done by using the following statistical techniques.In methodology, following techniques are used in this study to validate the findings and to get best solution. Techniques are, 1. Ratio analysis 2. Co-efficient of correlation 3.

Regression analysis 1. Ratio analysis financial ratios are used to evaluate profitability, liquidity, solvency, and capital market strength. This is particularly important when attempting to compare the efficiency of one business with that of another.

(1). Liquidity ratio A. Current ratio: Current ratio is a measure of the firm’s shirt-term debt maturing in current year.Current assets in rupees for every one rupee of current liability. A ratio is greater than one means that the firm has more current assets than current liability. As a conventional rule, a current ratio of 2-to-1 or more is considered satisfactory. It is calculated by dividing current assets by current liabilities. Current assets Current liabilities B.

Quick ratio Quick ratio establishes a relation between quick or liquid assets and current liabilities. An asset is liquid if it can be converted in to cash immediately or reasonably soon with out a loss of value.Generally, the quick ratio of 1to 1 is considered to present a satisfactory current financial condition The quick is found out by dividing quick assets by current liabilities. Formula is: Current assets-inventory Quick ratio = Current liabilities (2). Efficiency Ratio A. Debtor conversion period The ability if a company to collect from its credit customers ina prompt manner boosts the company’s liquidity. It measures the the efficiency of a company’s credit and collection policy.The ratio shows the number of days it takes to collect average accounts receivable.

Debtors Credit sale per day B. Inventory conversion period. This ratio shows the number of days a company’s inventory is turned into cash. Investment in inventory represents idle cash.

The lesser the inventory, the greater the cash available for meeting operating needs. Average stock Cost of good sold per day (3). Profitability Ratio A. Gross profit ratio This ratio indicates the average margin obtained on goods sold. It is calculated as under, Gross profit * 100 Sale B. Net porofit ratio This ratio is a measurement of profitability.This is an over all measurement of profitability. This ratio is calculated as follows, Net profit * 100 Sale C.

ROCE This ratio measures the overall profitability of the company. The term investment or capital employed means net fixed assets plus net working capital. The ratio is computed as follows, EBIT *100 Capital employed 2. Correlation Analysis In order to understand the relationship between working capital management and profitability, Correlation analysis is used. Correlation is concerned with describing the strength of the relationship between two variables by measuring the degree of “scatter” of the data values.This is achieved through a correlation of coefficient. Normally represented by symbol “r” It is a number which lies between -1 and +1 (inclusive). This is -1 ? r ? +1.

A value of r = 0 signifies that there is no correlation present, while the further away from 0 (towards -1 or +1) r is, the stronger the correlation. Correlation analysis is the statistical tool that can be used to describe the degree to which one variable is linearly related to another. In order to carryout the research techniques that correlation analysis are being used to find out the relation between variables.The value of this co-efficient is calculated by the following formula.

In this analysis the co-efficient of correlation between selected ratios relating to working capital management and profitability are presented. 3. Simple and Multiple Regression Analysis. In order to understand influence on profitability, a linear multiple regression models were used. Multiple correlation and multiple regression techniques have been applied and impact of working capital on profitability of the company, the regression coefficients have been tested with the assistance of the most popular ‘t’ test.

In this study Inventory conversion period (ICP), Debtor conversion period (DCP), Creditor conversion period (CCP) and Cash conversion period (CCP) have been taken as the explanatory variable and ROCE and NPR have been used as the dependent variable. For the purpose of selection of variable in this analysis, the correlation matrix representing the correlation coefficients between the explanatory variables has been constructed. The regression model used is this analysis is hereunder.

ROCE=b0 + b2 ICP + b3 DCP+b4 CCP +b5 CCP Where b0, b1, b2, b3, b4, and bs are the parameters of the ROCE line to be estimated.The pooled regression results of the models exhibiting the impact of working capital on profitability of the company. 3. 7 Hypotheses of study Possible hypothesis are formulated based on literature, Conceptualization of the research problem and research topic. Since the objective of this study is to asses the relationship between working capital management and profitability, finally hypotheses are examined whether it is acceptable or not. This research is conducted based on the following hypothesis . H1-: There is positive relationship between working capital management and profitability. .

8 Operationalization In this operationalization, research attempts to bring evidences to prove whether the situation described by the concept or variable exist or not. In this session, research identifies indicators for each variable and measures for this indicators. |concept |variable |indicator |measure | |Working capital management |Liquidity ratio |Current ratio |Current assets | | | |Current liabilities | | | |Quick ratio |Quick assets | | | | |Current liabilities | | |Efficiency ratio |Inventory conversion period |Average stock | | | | |Cost of good sold per day | | | |Debtor conversion period |debtors | | | | |credit sale per day | | | |Creditor conversion period | | | | | |creditor | | | | |credit purchase perday | | | |Net profit ratio | | | | | |net profit * 100 | |Profitability | | |sale | | |Profitability ratio |ROCE | | | | | |EBIT *100 | | | | |Capital employed | 13. LimitationIn the circumstances of any event, there are many limitations. It is impossible to get all data to the research accurately and sufficiently.

The identified limitations are as follows; • In this research only using secondary data. • In this research, the researcher selected only trading firms are taken from the financial statement of listed companies by the Colombo stock exchange and do research based on the the five years data between the 2003-2007 • This research report should be submitted with in short period of time. 3.

7 Summary This chapter has discussed the conceptualizing the research problem and discussing the method of data collection and data analysis techniques.To test hypothesis sample were collected from hand book of listed companies in 2008. In the next chapter an attempt is made in relation with data presentation and analysis. [pic] ———————– Amount of working capital Payment Collectionnnnnnnn Credit sale RMCP+WIPCP+FGC Payable Not operating cycle Receivable conversion price Inventory conversion period Gross operating cycle Purchase Amount of working capital (RS) Temporary working capital Permanent working capital Working capital Management Inventory conversion period + Debtors’ conversion period – Creditor conversion period = Cash conversion period Profitability ROCE Net profit Ratio n? xy – ? x? y n? x2 – (? x)2 n? y2 – (? y)2 r =

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